The Decline of Coal Is Bad News for More Than Just Miners

The coal and railroad industries are intrinsically linked. To understand and know how the railroads will perform, check with the coal industry.

Gone are the days when an engineer shoveled coal into the engine of a locomotive to keep it running. Trains run on far more efficient (and safer) methods of fueling now. But coal and railroads are still intrinsically linked, both industries relying upon the other for success and profits.

Coal is a cheap source of electricity production, provides thousands of jobs, heats homes and businesses, and needs the railroads to transport it around the country. Other resources, such as natural gas, solar, and hydro, are increasingly popular as sources of power generation, but coal remains the dominant resource around the world and in the U.S. However, natural gas and renewables are quickly eroding coal's earnings and market share. And with it, railroad profits.

According to a report by Industrial Info Resources, active coal mining projects in the U.S. have declined by 39% from 2011 levels. Active coal projects' earnings have declined from $12.3 billion in 2011 to $7.5 billion in 2013. The railroad industry has been significantly affected by the decline in coal shipments.

Eroding profitsCSX (NASDAQ:CSX) reported a 14% drop in quarterly profit. Compared to the same period a year earlier, revenue and volume grew 2% and 3%, respectively. However, operating income declined 16%, to $739 million, and earnings of $398 million, or $0.40 per share, represent a 14% decline from the $462 million, or $0.45 per share, in the first quarter of 2013.

During the first quarter 2014, coal revenue declined 9% from the same period in 2013, although volume fell by just 1%. In 2010, coal accounted for 31% of CSX's revenue. In 2013, it slipped to 24%.

Virginia-based railroad Norfolk Southern (NYSE:NSC) posted first-quarter net income of $368 million, or $1.17 per share, an 18% drop from $450 million, or $1.41 per share, last year. The railroad's operating revenue was $2.7 billion, down 2% from the first quarter of 2013.

Coal shipment revenue dropped 15% in the first quarter. The company said that the 18% drop in quarterly profit was due in large part to the falling demand for coal transportation.

Norfolk Southern's coal franchise, which includes serving about 100 coal-burning power plants, is its largest commodity group as measured by revenue. Coal accounts for approximately 23% of total operating revenue, according to the company's 2013 annual report.

"Coal continues to be the wild card, with utility volumes more stable but export volumes more uncertain," Norfolk Southern CEO Wick Moorman told analysts during a teleconference.

Canada's second-largest railway, Canadian Pacific Railway (NYSE:CP), reported first-quarter total revenue increased just 1% to $1.5 billion, yet operating income increased by 17% to $423 million. And net income of $254 million, or $1.44 per diluted share, increased 16% from the year-ago period.

Canadian Pacific reported a 1% decline in revenue for coal, a 12% drop for fertilizer, and auto and forest products decreased 9% each. It is possible that Canadian coal exports will lead to higher revenue and earnings in the coming quarters. Canadian Pacific is expected to benefit from its coal agreement with Teck Resources.

Exception to the ruleUnion Pacific (NYSE:UNP) is the exception to the expected coal-related problems. Where the other companies saw a decline or minimal improvement, Union Pacific posted overall revenue growth of 6% in the first quarter of 2014 to reach $5.6 billion; and it actually saw coal revenue grow by 3%. Additionally, it hauled 5% more carloads of freight in the quarter. Growth in revenue was driven by a 5% increase in volume and 1% increase in average revenue per car. The company improved net earnings by 14% to approximately $1.1 billion, driving a 17% increase in earnings per share.

In 2013, Union Pacific's coal revenue was down 6%, due in large part to the natural gas glut. Now that the glut has reversed and natural gas prices are rising, demand for coal is rising again as well.

OutlookThe outlook for railroad companies, and other coal-related industries, is not dim. Domestic coal demand had been down for some time due to competition from the lowered natural gas prices. However, things have changed. And as is seen with Union Pacific, natural gas prices are now on the rise, bringing back demand for coal. The favorable conditions should continue to drive growth in coal shipments in the second quarter for each of the railroads.

Additionally, the demand for thermal coal is expected to recover as power producers switch back to coal due to a recent run-up in natural gas prices.

The least predictable variable in railroad profits also has the potential to turn things around. Each company cited harsh winter weather as a problem. Harsh winter weather pushed CSX's quarterly expenses up 9% to $190 million. Union Pacific had to add 550 employees and 600 locomotives during the first quarter because the cold temperatures forced it to use shorter trains and shift some switching operations to different locations, leading to a 3% increase in expenses.

Canadian Pacific said the coldest winter in years reduced its quarterly profit by up to $0.30 a share, drove up expenses by $25 million, and cost it $75 million in revenue.

The good news is that utilities burn more coal during a hot summer to satisfy electricity demand for air conditioning. Higher demand for coal would boost coal shipments. Moorman said in a statement, "Following the extreme winter weather across the U.S. rail network which affected first-quarter results, we are seeing a rebound in shipments across all of our business."